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Saturday, November 19, 2016

India’s Lesson in Demonetization

This article was first published by the Global Association for Risk Professionals on November 18, 2016.
http://www.garp.org/#!/risk-intelligence/operational/political/a1Z40000003McKvEAK/indias-lesson-in-demonetization

The victory of Donald J. Trump in the U.S.
presidential election was not the only surprise in the global news on November
8, 2016. That evening, Indian Prime Minister Narendra Modi addressed the nation
and announced that Rs500 and Rs1000 currency notes would “cease to be legal
tender,” effective at midnight. “This step will strengthen the hands of the
common man in the fight against corruption, black money and fake currency,” he
said.

The scheme in 1978 was not deemed to be very
effective, as “the element of intended surprise and secrecy was also not well
maintained and thousand rupees notes were already out of circulation one week
before the demonetization. Reportedly large amounts of high denomination notes
were sent to Gulf countries, especially to Dubai and Kuwait, a few days before
the ordinance was announced.” (Kishore C. Samal, Chasing Black Money in
India) http://www.ispepune.org.in/PDF%20ISSUE/1992/JISPE2/Chasing-Black-Money-in-India.pdf

So secrecy became an absolutely necessary
condition. Any leaks would have rendered the entire exercise futile by tipping
off the black-money hoarders.

In a 1976 paper, On Black Money, http://www.jstor.org/stable/pdf/42657322.pdf
K. Sundaram and V. Pandit wrote, “Since it is infeasible to demonetize
currencies of all denominations, the success of this policy [demonetization] turns
on the extent to which black liquidity is in the shape of currency of the
denominations to be demonetized.”

Data from the Reserve Bank of India show that 86%
of all currency in circulation is in the Rs500 and Rs1000 denominations,
amounting to Rs14.2 trillion, or $212 billion.

Sundaram and Pandit added: “. . . insofar as the
measure is anticipated in advance by some and conversion of currency in the
relevant denominations takes place, success of this measure is further eroded.”

The policy did not take care of black money in the
form of real estate or gold or other non-currency assets. There are expectations and rumors of
crackdowns in the near future on those who have bought real estate and gold
through black money.

Those who got Rs500 and Rs1000 notes converted were
handed Rs2000 notes by the banks; Rs100 notes were available at automated
teller machines (ATMs). The long queues at ATMs, and out-of-order ATMs,
indicated that many people were either without cash or, with Rs2000 notes, were
unable to complete small-value transactions because retailers, unequipped with
smaller-denomination notes, were not willing to accept the Rs2000 notes.

As a result, many people who had never used debit
cards began to do so. Many small retailers and suppliers of daily provisions
started asking people to pay by card, cheque or digital wallets – cashless
modes of transactions that will bring greater transparency and help curb the
creation of black money in the future.

Inflation
and Taxation

Dr. Arvind Panagariya, vice chairman of NITI
Aayog, http://niti.gov.in/ told the
Economic Editors’ Conference—2016 that “as the black money goes out of the
system, the money supply will shrink to some degree. This will reduce inflation
rate in the absence of any open market interventions by the Reserve Bank of
India.”

A drop in inflation, coupled with banks deposit
flows, will give the RBI room to lower interest rates in the future.

The scheme is designed in such a way that people
hoarding large amounts of undeclared income in cash will find it difficult to
dispose of that cash. There are no limits to deposits of Rs500 and Rs1000
denominations, but it has been made clear that deposits above Rs250,000 would
be scrutinized and matched with the account holders’ income tax returns.
Mismatches could lead to penalties of 200% of the tax
payable, along with the payment of the tax payable.

Modi Initiatives

One of the reasons for the Narendra Modi government’s
coming to power was public reaction to scams and corruption. Modi promised to
fight corruption and bring good governance and in his November 8 address listed
previous measures taken:

·A law passed in 2015 requiring disclosure of
foreign black money.

·Agreements with many countries, including the
U.S., for sharing banking information.

·A strict law in force from August 2016 to curb
benami (nameless or fake-name) transactions.

The prime minister told the citizens that almost
Rs1.25 trillion was uncovered due to these efforts in the last two and a half
years. He vowed that many more measures will come in the future.

Acknowledging the inconveniences, Modi implored the
citizens to be patient and support the fight against corruption – to accept
temporary hardships in the interest of a better India.

Political
Reaction

Although the national mood seems generally
positive, there was strong opposition from other political parties. Indeed, many
political activities in the country are funded with black money.

Then there are cynics. To them, I would suggest an
analogy: Corruption and black money is like cancer. A patient might prefer to
withhold information from doctors in order to avoid painful treatments, or
might want to avoid treatments without 100% assurance of a cure, which is
unrealistic.

Tackling black money is important and should not be
avoided. No amount of preparation will be enough in a country of 1.2 billion
people, and there is always room for improvement.

Singapore’s The
Independent hailed the demonetization, saying, “Modi does a Lee Kuan Yew to
stamp out corruption in India,” a reference to that country’s transformational
leader.

Time will tell if the policy will contribute
towards making India a fairer, transparent and corruption-free economy. Black
money and corruption are so deep-rooted that they cannot be completely
eliminated. More efforts and persistence will be required. To paraphrase Robert
Frost, there are miles to go before we sleep.